Backdating: What Is It?
Backdating is generally defined as the practice of marking a document with an earlier date than the date on which the document was actually prepared. The context of the usage largely determines whether backdating is viewed in a positive or negative light . For a claim to be protected by a product liability statute of repose, backdating a contract may be viewed as prudent and legitimate. Backdating a medical prescription may be viewed as unethical and potentially criminal. In addition to contracts and prescriptions, backdating commonly occurs in the context of certificates, mortgages and other financing documents.
Backdating Under the Law
Backdating is not always illegal or fraudulent. In some circumstances, backdating is completely legal and acceptable. There are many circumstances where backdating is accepted, or even required, in the business, tax and estate planning worlds, for example. Courts have also recognized lawful and explainable retroactive grant dates of stock options.
Courts in several jurisdictions have upheld lawfully backdated stock option grants. The key to the backdated stock options is that the corporation and the employees intended to have the same exercise price. Even if a board of directors approved the issuance of a stock option at fair market value on a specific date, it is acceptable that it was not actually issued until sometime later, when the share price may have increased, if both the company and the employee intended the exercise price to be the same as the market price on the date of grant.
Courts have held that there should be different treatment for options that are actually granted retroactively (legal) than for options that are approved retroactively (illegal).
Backdating in Business Agreements
In certain business contexts, backdating may be a relatively common and accepted practice. For example, employers may be permitted to backdate employment contracts if the terms of employment (including the salary, benefits, and general conditions of employment) have already commenced. Backdating in this context would serve the practical purpose of creating a legally enforceable written record of the terms of employment in the event of a dispute between the employer and employee. The terms of an employment contract are generally not enforceable until made in writing, and backdating the contract is a simple way of overcoming this problem.
Similar to backdating of employment contracts, backdating for insurance contracts is also permissible in certain circumstances. However, where the insured has subscribed the insurance and received the premium for a specified period, and afterwards it is found that the premium has been paid for a different period, the absence of a mutual understanding is not fatal to the formation of the contract. In contrast, if an insurer attempts to backdate a contract to extend coverage to a period during which the risk was not in existence, such backdating may result in an unenforceable insurance contract. Further, because of the sensitive nature of the subject matter (eg., land registration, agencies, and corporations), backdating in the context of land registration and company law in general are generally prohibited. In this context, backdating may be objectionable to the extent that it deprives persons of certain rights which they may have acquired through the absence of a notice of the rights in registration or through third party reliance through the absence of filing. In the context of land registration, the process of requiring that all transfers of ownership be registered is designed to provide notice of claims against the property. Generally, the law deems that until the transfer is registered, the transferor remains the legal owner of the property and any conveyances by the transferee to third parties are void unless the parties have not been misled to their detriment. Similarly, company law seeks to protect third parties from being misled concerning the status and capacity of a company to enter into agreements.
Backdating and Financial Statements
The area we are all familiar with is the effect of backdating on financial documents. A classic example is the well publicized Dell backdating scandal. Dell, Inc., reported that revenue in its books for 2003 included stock options that were backdated by at least six months. The practice of backdating stock options can result in the issuing company inaccurately recognizing compensation expenses. This in turn could cause a company to understate or overstate its operating earnings as reported to the financial markets. Federal Securities Law requires periodic filings by a company to disclose information about its financial condition and other material events. A company must register its securities so that members of the public have access to complete and accurate information concerning the company’s financial condition and business activities. In October 2010 representatives from the Securities and Exchange Commission and the Department of Justice filed criminal and civil securities and criminal tax charges against two former Dell executives. The allegations were that they orchestrated a scheme that resulted in the underreporting of income between 2002 and 2006. Litigation is now ongoing between Dell and its directors and officers insurance carriers concerning disbursements of the insurance funds. The insurance carriers are challenging the officers’ entitlement to indemnification by Dell arguing that the conduct complained of in the underlying litigation constitutes a "deliberate fraud."
Illegally Backdating, and What Happens If You Do
Engaging in illegal backdating can have serious and costly implications for both individuals and businesses. When backdating is deemed fraudulent, it can trigger a host of legal problems, including securities fraud lawsuits, shareholder class action lawsuits and SEC investigations. It can also lead to criminal charges for executives and companies. While backdating is not illegal per se, there are times when it crosses over that line, often through falsification of business records, which can put the executives and the company in a tough legal spot . Criminal charges include securities fraud, making false entries in books and falsifying records. Charges may also arise under the Sarbanes-Oxley Act, which provides for a fine and imprisonment up to 10 years for tampering with documents, among other things. Such charges often carry the possibility of jail time for the individuals and significant fines for the corporations. The financial ramifications of these charges can be significant, and pose an existential risk to a company’s business. Moreover, the risk of jail time for executives makes backdating a serious risk for any individual or business to take on.
How to Avoid Trouble With Backdating
To manage and mitigate risk, corporations (particularly publicly traded corporations) should adopt and implement policies requiring that – to the extent possible – all transactions be documented contemporaneously, such that the date on the documentation can be relied upon as factual. For transactions that may proceed, or need to proceed, before prepared documentation can be completed, companies can use "backdated" documents, but should avoid all questions of legality by relying on another document as the principal, contemporaneous, "backdated" document. In addition, corporations should ensure, or at least attempt to ensure, that documents evidencing their backdating of a document are all executed by the same party, or at least contained in the same file (such as an email file). Unfortunately, as we just identified in our recent post on the topic, the Court of Appeal of England and Wales recently issued a judgment which appears to potentially undermine the strength of that advice. To the extent that any documents are created or modified "after the fact," corporations should implement and execute policies to ensure the documents do not reflect evidence that would allow surmising that the documents were created or modified for impermissible purposes. In this regard, corporations should train their employees or affiliates to recognize the types of activities that will attract the most scrutiny, and either limit, or even prohibit, those activities. For example, those activities or practices include: (1) using backdated documents to obtain a benefit; (2) failing to contemporaneously memorialize a transaction; (3) modifying a document after the fact; or (4) covering up a modification of a document after the fact.
Backdating Case Studies
The fallout from backdating practices can be severe. The following case studies are among the most well-known instances where backdating led to severe legal and financial consequences.
Credit Suisse First Boston: Proxy Statement In 2004, Credit Suisse First Boston (CSFB) faced a class action suit for allegedly awarding its clients backdated trades and for not disclosing this practice in its proxy statements. The firm had executed trades for some institutional clients that it knew were only "buy orders," meaning that they would only execute the order if the price went down. However, it nevertheless backdated the orders and executed them at prices higher than the market price. CSFB ultimately settled out of court to the tune of $100 million.
A subsidiary, Credit Suisse Asset Management (CSAM), had been executing trades for most of its institutional clients based on the time zone in which the clients were located. So, when executing buy orders for its clients in California, CSAM backdated the trades by three hours, and when executing sell orders for the same clients, it did the opposite. This essentially "front-run" the trades—the practice of buying or selling on the same day when the broker knows that the client is going to trade those securities at some point during the day. This practice can lead to client loss of revenue, and allowed CSAM to "further enrich" itself.
In 2004, both CSFB and CSAM’s parent company, Credit Suisse Group, settled by agreeing to pay $100 million to settle the civil suits. In December of that year , the Securities and Exchange Commission (SEC) filed charges against the banks. In 2005, Credit Suisse Group agreed to a settlement with the SEC to pay $250 million and an additional $30 million in disgorgement. Eight executives settled individual charges by paying about $6 million collectively.
Broadcom: Managers Handed a "Get Out of Jail Free" Card The Broadcom Corporation’s board of directors discovered in 2006 that the company’s finance department granted options to eligible employees a few days in advance of public announcements of positive earnings. In essence, the options were backdated, and executives sold their options to the stock at the high price that prevailed at the time the company issued the backdated options. In February of 2010, the company agreed to pay $12 million to shareholders to settle a shareholder derivative suit.
However, in August of 2010, the company agreed to an understanding with the SEC that individual executives could avoid prosecution if they agreed to the settlement and paid compensation for the backdated options. The understanding effectively immunized all managers and executives from criminal prosecution. Additionally, Broadcom agreed to pay $8.4 million in disgorgement and lost interest.
These are a few examples that demonstrate how individuals in management and executive levels might be penalized for underhanded strategies that negatively impact shareholder clients. While the aforementioned organizations were more or less unique, the lessons individual companies can take from these examples are universal.